Is Babcock Cheap? - The Final Day

A few years ago I read a book called No Two Alike by Judith Rich Harris, which Charlie Munger had recommended at the Berkshire Hathaway AGM. In it, Harris marvels at how different children can be, even those born to the same parents and raised under the same roof. Her argument is that there is no ‘right way’ to bring up a child; you need to adapt your child-rearing approach to suit a child’s strengths and weaknesses.

I know nothing about raising children, but valuing businesses is no different. The aim is always to work out how much cash is going to end up in shareholders’ pockets and when. But there is no ‘right’ way to work that out – you need a different approach for each different type of business. For a business with consistent and reliable earnings, a simple price-earnings ratio is a useful and accurate tool. For a business that goes through regular ups and downs you might use a PER but adjust the earnings to the average you expect over the cycle.

In some cases it might be more relevant to focus on a company’s asset backing, or book value, and its return on those assets. Sometimes you know the cash flows aren’t going to be consistent but are reasonably predictable, in which case a simple discounted cash flow analysis might be useful (see my research on RHG Group for a specific example). And you may find that one method suits one part of a company, while another suits a different part.

Which is the conclusion I’ve reached with Babcock. If I had to describe it in a sentence, I’d call it a combined funds management/private equity business. There aren’t really any comparable listed companies in Australia but Babcock has a lot in common with the US private equity group Blackstone (listed on the NYSE).

Although the funds management and private equity businesses are intertwined, I want to pull the two apart and value them separately. The funds management side is relatively straightforward and we’ll start there.

Locked in and risk free

Babcock had $72bn in funds under management (FUM) at 31 December and it earned $217m in base fees in the prior year. The GPT joint venture will probably be unwound and depressed stock markets will put a dent in FUM this year, but the reduction won’t be as significant as you might expect: 44% of the FUM at 31 December was unlisted and most of the listed funds pay fees based on enterprise value, which includes the debt component.

And the average funds under management last year would have been about $58bn, given the balance at the start of the year was only $44bn. So even if the FUM fell to less than $72bn this year, the average balance should still be higher than last year and so should the fees – I’d hazard a guess at something like $250m.

These management contracts are worth a lot more than the base fees though. Babcock is also the preferred advisor to all its funds, so every time they do a deal Babcock collects another pile of fees. Again, these fees might be at risk, especially if the funds were forced to appoint genuinely independent boards, but if things continue as they are I’d reckon on at least $140m a year in fees (they banked $340m in advisory fees last year but that should be considered abnormal given the amount of new funds raised). I’m basing the $140m off 20% turnover in the funds, or $14bn of deals a year, and a typical 1% fee paid to Babcock.

So, if Babcock were to offer me this funds management and advisory business, I’d estimate a total of $390m a year as a sustainable level of revenue. Assuming the overall cost-to-income ratio of 60% applies to this income (that’s the average across the Babcock business), it would translate into $150m-odd in pre-tax earnings.

Given the current market ructions and questions being asked about Babcock’s business model, there’s obviously a risk that some of this revenue will disappear. But it’s a very attractive revenue stream, which doesn’t really require any capital, and seven times pre-tax earnings, or $1bn, seems a reasonable price tag (assuming no growth and targeting a post-tax return of 10% after a standard 30% company tax charge). That number also translates nicely to about 1.4% of funds under management, a fairly typical valuation for a business such as this (see James Greenhalgh’s Platinum against the world series).

That’s the most attractive part of the business. There is no capital at risk and most of the contracts last at least another 20 years. Unfortunately, it’s nowhere near enough to justify the current share price. In fact, it’s not even half the value of the $2.7bn debt, so there needs to be significant value in the private equity side of the business – and that’s a lot more difficult to get a handle on.

Lots of assets and almost as much debt

The value in the private equity side lies in the assets currently sitting on the balance sheet and Babcock’s ability to buy more and sell them at a profit in future. It has been very good at this for the past four years, but four years of boom-time profits hardly constitutes a track record.

And it’s the value of the assets currently sitting on the balance sheet I’m most concerned about. Babcock’s balance sheet grew by more than 60% last year – adding about $6bn of highly geared assets in the space of 12 months. Working out what those assets are worth is next to impossible, but what I do know is that there isn’t much margin for error. If the $15.6bn of assets turned out to be worth 10% less than their current balance sheet value, Babcock’s $5bn equity share (the rest is limited recourse debt) would be knocked down to $3.4bn. Make that 20% less and you’d be down to less than $2bn which, by the time you subtract the $2.7bn of corporate debt, would mean negative shareholders’ equity. In a world where credit is hard to come by and expensive, 10 or 20% is hardly inconceivable.

Babcock’s leveraged assets

Division

Assets

Liabilities

Net assets

Potential impairment

Conservative net assets

Real estate

$5.4bn

$3.7bn

$1.8bn

20%

$691m

Infrastructure

$5.9bn

$3.7bn

$2.2bn

20%

$1.1bn

Operating leasing

$1.9bn

$1.6bn

$358m

10%

$165m

Corporate and structure finance

$967m

$386m

$581m

0%

$581m

Total

$14.3bn

$9.3bn

$5.0bn

$2.5bn

Of course, it’s possible some of the assets are worth more than their balance sheet value – the sale of its wind assets in the next three months is expected to generate a significant profit. And, if my experience in this area is anything to go by, the structured finance assets should be very safe.

But Babcock also has more than $1bn invested in its own funds with a current market value of about $600m. It is, put simply, impossible to estimate with any degree of confidence what these assets are going to be worth to shareholders.

Too murky for me

Picking up stocks on the cheap often requires special insight or a better understanding of a business than others. But it doesn’t require any special mathematics. When you find something cheap, it should be blatantly obvious that it’s cheap. Whichever way I look at it, there’s nothing blatantly obvious about the value on offer here.

It might not always be like that. Were it to sell some assets at attractive prices and pay down debt, the situation might become much clearer. If I could buy it for less than the value of the fund management contracts, for example, I’d get pretty excited. As it is, it remains one for the too hard basket. I’ll continue to cover it in The Intelligent Investor but I’m keeping the recommendation as AVOID.

The preference shares (ASX code BNBG), on the other hand, look tempting. There’s a real risk of a wipe-out, but they’re yielding north of 50%** a year to the first reset date on 15 November 2010 (including dividends and capital gains). I’d suggest it’s going to be very hard for the ordinary shares to beat that over the next couple of years. And while I’m not convinced the shares are worth their current market price, there’s enough value in the locked-in management contracts and the assets on the balance sheet to give those holding the preference shares some comfort that the company can meet its obligations.

We’re seeing a lot of value in listed income securities at the moment and this looks like one to add to the list. I’ll publish a proper review on The Intelligent Investor soon, but it looks like much better value and a lot less risk than the ordinary shares.

So that brings an end to this 10-day series that ended up taking a month. It’s an interesting business, Babcock, and I wouldn’t be at all surprised to see it confound the sceptics and prosper. But it seems impossible, for now at least, to determine whether it has a competitive advantage or has simply ridden the infrastructure boom of the past five years.

** Correction: The yield to maturity is actually 34% at a price of $69, not north of 50% as suggested. You can read our review of BNBG here.

Disclosure: The author, Steve Johnson, owns shares in RHG Group. Other staff members own shares in RHG and Platinum Asset Management.

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